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Valspar Corp. (NYSE:VAL)

F4Q07 (Qtr End 10/26/07) Earnings Call

November 19, 2007 11:00 am ET

Executives

Paul Reyelts - EVP and CFO

Bill Mansfield - Chairman, President and CEO

Lori Walker - VP, Treasurer and Controller

Analysts

Steve Schwartz - First Analysis

Saul Ludwig - KeyBanc Capital Markets

Don Carson - Merrill Lynch

Dmitry Silversteyn - Longbow Research

Rosemarie Morbelli - Ingalls & Snyder

James Sheehan - Deutsche Bank

Sergey Vasnetsov - Lehman Brothers

Bob Koort - Goldman Sachs

P.J. Juvekar - Citi

Silke Kueck - J.P. Morgan

John McNulty - Credit Suisse

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Fourth Quarter Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Instructions will be given at that time. (Operator Instructions) As a reminder, this conference is being recorded.

I'd now like to turn the conference over to your host, Paul Reyelts. Please, go ahead.

Paul Reyelts

Good morning, everyone, and welcome to our year-end Earnings Call. Today, we will be covering results for the fourth quarter and the full year. Bill Mansfield and Lori Walker are with me on our call this morning.

I'll make a couple of brief comments before we begin. First, I would direct your attention to the press release we issued this morning, which contains much of the information that we will be covering in the call. Also, a quick reminder, that this call is subject to the "forward-looking statements" language contained in our press release. We will be making comments this morning that may include "forward-looking statements" as that term is defined by securities law.

So I'll cover our fourth quarter and full year results and Bill will make a few comments and then we'll get to your questions.

Turning to the fourth quarter, our operating results were in line with what we discussed in our October 1st press release and on an adjusted basis at consensus of $0.40 per share. Fourth quarter sales totaled $852.8 million, up 8.8 % from last year. A result of increased sales in our businesses in markets outside of the U.S. is primarily related to our recent acquisitions.

Adjusted for currency and acquisitions, sales were up 1.9% with the largest factor being soft sales in our architectural and wood coatings product lines. The two businesses most affected by continued weakness in U.S. residential construction and housing markets.

Our architectural sales in the second half did show improvement compared to the first half of the year. Net income for the quarter was $48.8 million. Adjusted earnings per share were $0.48 for the quarter, which includes an after-tax gain of $0.10 per share from the sale of assets and a $0.02 per share charge for an unfavorable tax adjustment, which I'll explain in a minute. And this number excludes a $0.03 per share non-cash adjustment for the Huarun minority interest shares.

Reported earnings per share were $0.45. In 2006, fourth quarter earnings were $52.1 million, or $0.51 per share, which included a $0.01 per share charge for manufacturing rationalization and a net gain of $0.03 per share resulting from favorable income tax adjustments.

Excluding adjustments, the underlying EPS comparison for the fourth quarter is $0.40 per share in 2007 and $0.49 per share in 2006.

For the fourth quarter, our gross margin was 29%, down from 31.5% in the fourth quarter of 2006 and down from 31.6% when adjusted for last year's manufacturing rationalization.

Now, about 1% of the decrease is due to three non-recurring items that we discussed in our last call: one, manufacturing efficiencies resulting from inventory reduction; two, downsizing of an industrial manufacturing plant; and three, manufacturing startup costs in Brazil.

Roughly, another percentage point is due to lower U.S. volume in our higher margin Paints segment, specifically, architectural and automotive refinish coatings and a little more than a half point is due to increased raw material costs.

Operating expenses were 20.1% for the quarter, down two-tenths of a percent from 20.3% in 2006 with lower incentive compensation costs, partially offsetting our investment in brand building. The fourth quarter operating margin was 8.9% versus 11.2% last year.

The tax rate for the fourth quarter was 36%. The higher tax rate is related to an estimated reevaluation of our China entities' deferred tax accounts to reflect recent changes in Chinese Tax Law. Said another way, we expect our tax rate in China to be up going forward. And so, we are adjusting our deferred tax accounts to reflect that expectation on our part. We expect the effective tax rate on income from ongoing operations to be approximately 33% to 33.5% for fiscal 2008.

Average shares outstanding were down $1.1 million from a year ago, with the decline related to the accelerated share repurchase that we completed in the second quarter. During the fourth quarter, we didn't purchase any additional shares.

Average shares outstanding were $101.8 million for the quarter and are projected to be a $102 million for the first quarter of 2008. As a reminder, we purchased approximately 2.6 million shares in 2007.

Recapping our sales performance for the quarter, our core growth defined as volume, price mix combined was up 1.9%. Currency added 2.6% and acquisitions added another 4.3% for total net growth of 8.8% in the quarter.

Now, turning to our segment results, Paint sales increased 5.7% and were basically flat when adjusted for currency and acquisitions, reflecting the impact of soft architectural sales.

Coatings sales increased 11.8% and were up low single-digit when adjusted for currency and acquisitions. As mentioned previously, coating sales were impacted by soft sales in our wood coatings product line related to furniture and new construction markets.

General industrial sales were also somewhat soft, while our coil coatings achieved a solid performance in the fourth quarter. Packaging coatings was our strongest sub-segment, up high single-digit and up mid single-digit when adjusted for currency.

Sales in our other category, which includes resins, colorants, gel coats and our furniture repair business, were up 1.4% and down slightly when adjusted for currency and for acquisitions.

Looking at the full year, our Paints segment sales increased 10.5% and were down low single-digit when adjusted for currency and acquisitions. Also for the full year, our Coatings segment was up 10% and basically flat when adjusted for currency and acquisitions.

Again, our best sales performance came from Packaging Coatings, which was up high single-digit for the year and up mid single-digit when adjusted for currency. And our Other segment was flat for the year and when adjusted for currency and acquisitions, down low single-digit.

Addressing margins for the quarter by segment, our Paints segment EBIT margin was 7.4%. Now adjusting for the brand spend, our Paints segment EBIT margin would have been just under 11% for the quarter, down from 12.7% in 2006 due to manufacturing inefficiencies resulting from our inventory reduction actions.

Our Coatings segment EBIT margin was 11.8% for the quarter, down from 12.9% for the fourth quarter of 2006. The EBIT margin for our Other category, which includes our corporate expenses, was 14.3% compared with negative 4.8% last year. The increased in Other EBIT was due to the one-time sale of assets mentioned in our press release. And excluding the gain, our Other EBIT margin would have been comparable to last year.

Total company EBIT margin was 10.7% for the quarter, down from 11% in 2006 and without the asset sale, this year's EBIT margin would have been 8.7%.

Looking at the full year, our Paints segment EBIT margin was 9.7% versus 10.9% in 2006. The Coatings EBIT margin for the year was 10.7% compared to 12% last year. And the Other segment margin was positive 5.6% reported and positive 0.3% adjusted for the gain on sale of assets versus negative 1.9% in 2006. Total company full year EBIT margin adjusted for the asset gain was 9.4% compared to 10.2% last year.

So now, I'll move to the balance sheet. Total debt at the end of the fourth quarter was $1.17 billion, up $178 million from the $839 million at the end of last fiscal year. The increase is due primarily to $172 million for acquisitions and $72 million of share repurchases.

We are now estimating that year end debt for fiscal 2008 will be $850 million to $875 million, assuming no additional acquisitions or share repurchases. Our year end debt-to-capital ratio was 42.4% with net debt-to-capital at 40.3%.

Capital spending in the fourth quarter was $29.2 million, down from $35 million in last year's fourth quarter. And for the full year, capital spending was $76.9 million versus $75.4 million in 2006. Our forecast for 2008 capital spending is $60 million to $65 million.

Depreciation and amortization for the fourth quarter totaled $20.3 million versus $17.7 million in the fourth quarter of 2006. Our full year depreciation and amortization was $71.8 million versus $68.7 million last year. The fourth quarter and full year depreciation expense figures from last year include the impact of our manufacturing rationalization.

Our forecast for depreciation and amortization combined in 2008 is approximately $75 million. As mentioned in our release, our adjusted earnings per share from operations this year were $1.58.

Looking to fiscal 2008, at this point, our current expectation is for 2008 adjusted earnings per share to be in the range of $1.65 to $1.75. This assumes no improvement in economic conditions in the U.S., raw material increases in the 2% to 3% range and modest improvements in our pricing. This would represent approximately a 4% to 10% improvement in EPS from operations, which we think is reasonable, given our outlook for the U.S. economy.

For 2008, we expect low double-digit sales growth in our packaging and auto refinish businesses and in Huarun Paints in China. These businesses represent about 30% of our total sales and are largely focused on faster growth markets outside of the U.S. For the balance of our businesses, we anticipate low single-digit growth exclusive of acquisitions, reflecting our conservative outlook for the U.S. economy.

With those comments, I would like to turn the call over to Bill Mansfield now.

Bill Mansfield

Thank you, Paul, and good morning, everyone. As Paul mentioned, in the fourth quarter we did exactly what we said we would do on our October 1st call. Clearly, 2007 was a difficult year for us.

At the beginning of the year, we felt the impact of the slowdown in the U.S. housing markets, particularly in our wood business and our architectural business. And, as the year progressed, we saw a slowdown start to occur in our coil business, particularly in our appliance part of our coil business and our general industrial business.

Now those difficulties inside the U.S. were offset to some extent by reasonably good markets outside of the U.S. During 2007, we restored our U.S. wood coatings business to profitability by restructuring during the first half of the year such that we could earn reasonable profits in a depressed marketplace.

Our packaging business did quite well during the year, particularly inside the U.S. and we had good performance in our international operation, particularly Fuller, Tekno in Braziland Huarun in China.

We are pleased with our branding progress. We have made consistent gains in consumer awareness since our launch and we are in the process and have developed new business opportunities with the Valspar and Cabot branded products. And we have expanded our global presence through acquisitions, Tekno in Brazil, Teknos in Eastern Europe adds to our growing presence in China with the Huarun acquisition.

I would like to say a brief word on Teknos. We announced this acquisition in the beginning of October. In 2006, Teknos had sales of approximately $42 million or EUR31 million. It provides Valspar with an immediate growth platform for coil coatings in fast growing markets of Central and Eastern Europe, Russia and the Baltic States and we are quite pleased to have had the opportunity to make this acquisition.

So, in 2007, we've made a solid progress on our growth initiatives of branding, expanding our global presence and executing on strategic acquisition opportunities.

Now, having said that we are not at all satisfied with our 2007 financial performance; as Paul said, for 2008, we expect a weak U.S. sales environment to continue through the year with the exception of our packaging business. And, we also expect reasonable market conditions in our international markets.

So, here is what we are doing to ensure improved 2008 performance. Over the last three weeks, I met with over 600 Valspar employees at their facilities around the world in the Americas, in Europe and Asia.

The purpose of these meetings was to ensure that there was a complete understanding and alignment on our strategy, that we had the appropriate focus on execution and that there were sound plans in place to generate and deliver new business even in the U.S. markets. To make sure that the opportunities to improve our operations have been identified that the plans with well-defined targets, milestones and accountability were in place and that there was a clear understanding of what needs to get done, translate that to execute to deliver improved financial performance in 2008.

I was quite pleased with what I saw and heard from our employees. They are pushing very hard on improvements in operations, and by operations, I don't just mean manufacturing, I am talking about closing new business opportunities, implementing needed and required price increases and prudent cost control around the globe.

We were successful in reducing our inventory. We indicated an objective of a 5% to 10% reduction over our ending third quarter levels and I am pleased to tell you that we reduced our inventories by close to 7%. The industrial plant downsizing we talked about in our October 1st call is nearly completed and should contribute to cost savings next year.

One other point I would like to make is I haven't talked a lot at least externally, about our Lean Six Sigma initiative that we launched internally at the end of '06. But I can tell you on a global basis, we have 291 active projects that are being worked on by Black Belts and Green Belts around the globe. And, as these projects are completed, they should result in meaningful improvements in the operations of our business.

So I came away pleased that we have clearly defined execution plans in place for all of our businesses and regions.

So with those comments, I would like to open it up for questions.

Question-and-Answer Session

Operator

Okay. (Operator Instructions) Your first question comes from the line of Steve Schwartz from First Analysis. Please go ahead.

Steve Schwartz - First Analysis

Hi, good morning.

Bill Mansfield

Good morning, Steve.

Steve Schwartz - First Analysis

Can you help me understand, if I look at the day sales or days of inventory, it looks like you have gone up slightly versus the third quarter, but you just commented you were down 7%. How are you looking at that or coming up with that 7% number?

Lori Walker

Steve, I think what you need to do is our fourth quarter includes Teknos acquisition.

Steve Schwartz - First Analysis

Okay.

Lori Walker

So, if you take the inventory up for the Teknos acquisition, it's actually down 7%.

Steve Schwartz - First Analysis

Okay. All right.

Lori Walker

Roughly.

Steve Schwartz - First Analysis

Okay. Can you give me that number, what that would be?

Paul Reyelts

That would be around $20 million reduction from the end of the third quarter.

Steve Schwartz - First Analysis

Okay, great. And then, it sounds like you are looking for FY '08 to get price increases that are about in line with what you expect raw material costs increases to be, is that right?

Bill Mansfield

That would be correct, Steve.

Steve Schwartz - First Analysis

Okay. So what we have seen here in the fourth quarter, I'm calling 55 basis points, we probably at this point just eat?

Bill Mansfield

No, I won't say that. I would tell you that pricing is a dynamic function and that we are looking for probably in the order of 2% to 3% year-over-year increase in our material costs next year. And so, I would include the 55 basis points, as you said, into our overall pricing efforts.

Steve Schwartz - First Analysis

Okay. And do you think that there is one channel retail or industrial, where you are more likely to get more of an increase. So, in other words your retail channels, do you think they are receptive to a price increase at this point?

Bill Mansfield

I would contrast the U.S. versus outside the U.S. as in a weak economic environment, it's a tough challenge, but our people will meet it, and I tend to look at it that way.

Steve Schwartz - First Analysis

Okay, great. Thank you.

Bill Mansfield

You're welcome.

Operator

Your next question comes from the line of Saul Ludwig from KeyBanc. Please go ahead.

Saul Ludwig - KeyBanc Capital Markets

Hi, good morning, guys.

Bill Mansfield

Good morning, Saul.

Saul Ludwig - KeyBanc Capital Markets

What were the final numbers on the brand building this year and what do you expect next year?

Bill Mansfield

Well, we've talked all along in 2007 and particularly in the October 1st call, that we would expect a decline next year of approximately $10 million or about $0.07 a share. We spent somewhere around $0.25 to $0.27 a share in 2007.

Saul Ludwig - KeyBanc Capital Markets

All right. What was the cash flow from operations for the year?

Paul Reyelts

Saul, we haven't done the cash flow statement yet.

Saul Ludwig - KeyBanc Capital Markets

Order of magnitude, Paul?

Bill Mansfield

What would you say, Lori?

Lori Walker

I'd [roughly get there too].

Paul Reyelts

Saul, I tell you why don't you let us get back to you on that?

Saul Ludwig - KeyBanc Capital Markets

Okay. No problem.

Paul Reyelts

We really haven't had a chance to do that yet.

Saul Ludwig - KeyBanc Capital Markets

Okay. On the raw materials, what was sort of the swing from the third to the fourth quarter, would you think there was any increase?

Bill Mansfield

Yeah, there was a small slight moment up.

Saul Ludwig - KeyBanc Capital Markets

Kind of like maybe 1% or so.

Bill Mansfield

Yeah, that would be in the ballpark, Saul.

Saul Ludwig - KeyBanc Capital Markets

Okay. Now the point that you made, Bill, about the Black Belts and the Green Belts and you made the change and you scaled down one of your industrial plants, if we were to look at the non-raw material costs as part of cost of goods sold, if you look at your operating expenses in the cost to goods sold why not the other operating expenses. Should they change, should they go down, should they go up, there is inflation, I mean given all the things that you're doing, what do you expect to achieve in '08 versus '07 in terms of your manufacturing costs exclusive of raw materials?

Bill Mansfield

I would answer your question this way, Saul. I don't have a quantitative answer for you. I would tell you this that I'm confident that ex-raw material, all those other things that you talked about, we will be more efficient in 2008 than we were in 2007.

Saul Ludwig - KeyBanc Capital Markets

So that number as a percentage of revenue whatever it was, should go down?

Bill Mansfield

That's a good way to measure efficiency, I'd agree.

Saul Ludwig - KeyBanc Capital Markets

Okay. And then finally, Paul could you give any more segmentation of the volume, price mix 1.9%. How does that sort of split up?

Bill Mansfield

Well Saul, I'll tell you what our volumes improved through the year, and also our price mix improved somewhat through the year.

Saul Ludwig - KeyBanc Capital Markets

I was talking about the 1.9% change fourth quarter to fourth quarter. I know that would assume price mix was more than 1.9%.

Paul Reyelts

That's correct.

Bill Mansfield

Yeah, that's correct.

Paul Reyelts

Price mix was more. Volume was slightly negative.

Saul Ludwig - KeyBanc Capital Markets

Okay. And could you give us any more granularity on that?

Paul Reyelts

No, sir.

Saul Ludwig - KeyBanc Capital Markets

Okay. And then finally, given the pulse of things, and within the context of your outlook for next year, should we be thinking that we're going to start out on the negative side with regard to how your first quarter might look without maybe any greater granularity but at least directionally, do you see first quarter being a tough quarter?

Bill Mansfield

Saul, we've not been in the practice of providing quarterly guidance and I would tell you that I don't think any quarter next year is going to be any easier or tougher than any other at this point.

Saul Ludwig - KeyBanc Capital Markets

Okay, great. Thank you very much, guys.

Bill Mansfield

You're welcome.

Operator

Your next question comes from the line of Don Carson from Merrill Lynch. Please go ahead.

Don Carson - Merrill Lynch

Yes, thank you. Paul, can you just comment on sort of your, I mean, you talked about the architectural coating difficulties we face. I know one of the raw material suppliers was talking about maybe a 5% down market in the U.S. again next year. What are you thinking of in terms of the strength of the architectural market, and what shifts do you see in channel? Do you think in an economic downturn that maybe more people might go DIY, which would work to Valspar's favor?

And then, a question for Bill. You talked about new branding opportunities or new sales opportunities as a result of your branding initiatives, if you could just expand on that?

Bill Mansfield

Let me try the last one first. I think it's premature to comment on any specific opportunity. I can tell you that the increase in consumer awareness clearly has gotten the attention of our major customers, and consequently has resulted in additional opportunities for both Valspar and Cabot brand, but it would be premature.

With respect to the architectural market, whether it's down 5% or not next year, I don't know. I can tell you that we for 2008 don't believe the market will improve at all, and that's how we put our business together.

We also believe that housing turnover is a key determinant as we view the market. And again, I know there is lots of discussion about difference in channel being professional or DIY, which is paint store versus big-box, and I don't think there will be any, at least we don't see any significant move one way or another in 2008.

Don Carson - Merrill Lynch

Thank you.

Bill Mansfield

You're welcome.

Operator

Your next question comes from the line of Dmitry Silversteyn from Longbow Research. Please go ahead.

Dmitry Silversteyn - Longbow Research

Good morning. Just a couple of questions. I want to make sure that I understand you correctly. The inventory correction that you carried out in the fourth quarter, you feel that you've gotten the inventory to the level that will support continuing slowing business in the United States?

Bill Mansfield

You bring up a good point, Dmitry. That 20 million was primarily in the U.S. and a lot of it was in our architectural business and I think those inventories are in reasonably good shape. There is always room for improvement in working capital, so we continue to focus on being more efficient users of working capital.

Dmitry Silversteyn - Longbow Research

Okay. But as far as you expect continuing weakness in the U.S., I'm assuming you are producing at slightly lower volumes throughout the year to reflect that expectation?

Bill Mansfield

That will be correct.

Dmitry Silversteyn - Longbow Research

Okay. But you don't think you are going to need to correct the inventories in a major way again?

Bill Mansfield

That would also be correct.

Dmitry Silversteyn - Longbow Research

Okay, excellent. General industrial business as far as coatings is concerned was okay in the first half of the year and then it sounded like in the third and fourth quarter, it seems to have gotten weaker?

Bill Mansfield

Yes.

Dmitry Silversteyn - Longbow Research

Can you kind of take us through the sequential, kind of month-to-month changes, and what you are seeing right now, and do you expect that business becoming a major source of weakness similar to architectural coatings in 2008, or do you thinks it's plateauing here?

Bill Mansfield

No. My sense is, I can't do month-to-month, we don't have that kind of…

Dmitry Silversteyn - Longbow Research

I understand, but at least directionally.

Bill Mansfield

Yeah, directionally. My sense is, Dmitry, that it's probably reached a plateau. I am concerned about the number of extended shutdowns that our customers have announced over the holiday period. Typically, you have perhaps two weeks and now it's three weeks, but having said, that talking to our customers I think we'd probably hit a plateau that I think will just stay at for 2008.

Dmitry Silversteyn - Longbow Research

Okay. And sort of packaging and the coil coating outside of the appliance applications as well as Huarun sounds like are going to be the driver and the automotive after-market, going to be drivers in 2008?

Bill Mansfield

Yes, our packaging business is doing quite well. We're really pleased with the performance. Huarun continues to do well. And certainly our coil business and frankly even parts of our general industrial business outside of the U.S. are quite healthy.

Dmitry Silversteyn - Longbow Research

Okay, very good. And then you mentioned that you expect raw materials to be up about 2% to 3% year-over-year in 2008. From what you're seeing right now and kind of where you're suppliers are coming to you with their proposals right now. Do you see a possibility of a spike in December-January period as we have a couple of years ago? Or do you think it will be more like last year, where it's more gradual increases through out the year.

Bill Mansfield

I think our suppliers have made a broad range of announcements that really were at the turn of the quarter, October 1st, a great number of them are still being negotiated. I think it's probably premature. Although I would say there is probably more pressure in the first six months of the year than the second half of '08.

Dmitry Silversteyn - Longbow Research

Okay. Thank you.

Bill Mansfield

You're welcome.

Operator

Your next question comes from the line of Rosemarie Morbelli from Ingalls & Snyder. Please go ahead.

Rosemarie Morbelli - Ingalls & Snyder

Good morning, all.

Bill Mansfield

Good morning, Rosemarie.

Rosemarie Morbelli - Ingalls & Snyder

A little clarification, Bill. You said that, you expect the weak environment to continue in the U.S. in 2008 and you also talked about plateau in, if I understood properly in the coatings area. Do you expect to continue an increasing decline in the other areas or plateau across the board?

Bill Mansfield

No, Rosemarie, in the U.S. we expect the current conditions, those conditions that we have experienced in our fourth quarter to continue for full year 2008.

Rosemarie Morbelli - Ingalls & Snyder

But not weakening further?

Bill Mansfield

No, we do not have any weakening further in our outlook.

Rosemarie Morbelli - Ingalls & Snyder

And if you could talk about Europe a little bit, because there are signs that Western Europe is slowing down. Are you seeing it, and how large is Western Europe as part of your international business?

Bill Mansfield

Well, having just been there, I would agree there is concern with respect to the strength of the Euro, the weakness of the dollar. And interestingly enough, they are also experiencing in some markets, Germany, UK decline in housing prices. Our biggest business and most important business in Europe is our packaging business. And that has demonstrated through the years a resiliency through the ups and downs of the economic cycle. And we anticipate we will have a good year in Europe in our packaging business in 2008.

Rosemarie Morbelli - Ingalls & Snyder

One thing, which if my memory serves me right, affects your packaging business is weather, the crops are good, salmon fishing and that sort of thing. Are you hearing anything and are you anticipating some of your end markets to be slower for one reason or another?

Bill Mansfield

Well, I will complement you on your memory Rosemarie, that's about every reason I have used, you captured in your comments. However, I would tell you that there are no unusual conditions that we see today that would negatively impact the business.

Rosemarie Morbelli - Ingalls & Snyder

And you are lowering your CapEx level substantially for next year, are you eliminating some previously anticipated projects, just pushing them out? Or do you feel that the reason is mostly that you are done with the branding and other big projects?

Bill Mansfield

No, I think it's more our prudent approach to 2008. We are pushing some projects back such that they would be done, second half of '08, first half of '09, which on a full year '08 basis will result in some reduced capital spending.

Rosemarie Morbelli - Ingalls & Snyder

What are we talking about, expansion of plans? Can you give us a feel for what you are pushing?

Bill Mansfield

No, these are mostly internal efficiency projects, replacement perhaps of some equipment with more efficient equipment.

Rosemarie Morbelli - Ingalls & Snyder

Wouldn't you benefit from doing that when you expect a low demand and get us as much efficiencies as you possibly can?

Bill Mansfield

As I've said, our judgment, we think the prudent thing to do is to conduct it the way I described it.

Rosemarie Morbelli - Ingalls & Snyder

And if I may ask one last question, regarding gross margin, it was 29% in the fourth quarter; 28.7% in the first quarter of '07, based on all of the steps you are taking and all of your comments and then less investments in the branding and so on. Do you expect next year's margin to be above those two low levels?

Bill Mansfield

I don't think we have looked it at that closely yet, Rosemarie. You're asking a quarterly question, I'd go back to my prior comment.

Rosemarie Morbelli - Ingalls & Snyder

No, for the full year, I am just using that particular level and looking at the full year. Those were the two lowest levels in '07. So, I am taking those.

Bill Mansfield

Flat, Rosemarie.

Rosemarie Morbelli - Ingalls & Snyder

Okay, thanks.

Bill Mansfield

You're welcome.

Operator

Your next question comes from the line of [James Sheehan] from Deutsche Bank. Please go ahead.

James Sheehan - Deutsche Bank

Thank you. Another question on raw materials, you referenced back in your previous call some pressure in Europe. Is that continuing, and do you expect more of that in '08 and could you tell us or give us a little more color on what types of raw materials you are seeing the pressure in?

Bill Mansfield

Well, at $95 a barrel of crude oil, we're seeing pressure across the board. I don't think there is any one particular segment that's outshining another. And we're seeing a continuing of a pressure in Europe on material costs. Fortunately, sometimes in the past, it's been perhaps just a group, propylene derivatives, as an example we have talked about in the past. But today, given the increase in BTU costs, be it gas and/or oil, it is pretty much across the board pressure.

James Sheehan - Deutsche Bank

And is your pricing in Europe keeping pace with the raw material increase just in Europe?

Bill Mansfield

We have pricing initiatives underway in Europe, and they have been underway for a while now to recover what we have experienced.

James Sheehan - Deutsche Bank

Okay. And you mentioned on the acquisition that you did in the Central and Eastern Europe area, is that an example of the type of M&A that we can expect in the future or can you comment a little bit more about the M&A pipeline?

Bill Mansfield

Well, the pipeline, there are still deals, potential deals that are under discussion. And I think your point about this is this the kind of acquisition we are likely to see Valspar make going forward. If you look at our history over the past three years that is exactly the kind of acquisition we have been making. And so, I would think that that's a pretty good bet for the future.

James Sheehan - Deutsche Bank

Okay. And real quickly on the all other segment, is the increase in there reflective of the gain on sale of assets?

Bill Mansfield

Exactly.

James Sheehan - Deutsche Bank

Okay, thanks a lot.

Bill Mansfield

You're welcome, James.

Operator

Your next question comes from the line of Sergey Vasnetsov from Lehman Brothers. Please go ahead.

Sergey Vasnetsov - Lehman Brothers

Good morning.

Bill Mansfield

Good morning, Sergey.

Sergey Vasnetsov - Lehman Brothers

Just briefly on the results, I think you should be proud of what you accomplished in conditions which are very challenging, because I certainly remember conversations a year ago in advance of the housing cycle decline, I think people have been circulating that, given your exposure you would have been -- you will be hit a little harder than you actually have been.

Bill Mansfield

Thank you for the compliment, Sergey.

Sergey Vasnetsov - Lehman Brothers

I want to ask you when you think [of below fuel] conditions September to October to November, even though November is just in the midst of the month, sequentially what kind of trends do you see?

Bill Mansfield

What kind of trends do we see?

Sergey Vasnetsov - Lehman Brothers

Yeah, on volume and pricing?

Bill Mansfield

On volume and pricing, September, October, November, certainly what I can comment on, is we got concerned. That's why we had the call on October 1st. We got concerned what we saw in September versus June, July, August, to a certain extent. And I would tell you that October, November continued about the same as September's performance. There wasn't any real significant change either up or down between either our Paint segment or Coating segment.

With respect to pricing, I presume you mean our finished, our pricing to our customers and we continue to execute on pricing initiatives that we had been doing pretty much all of 2007. They were selective rifle shot approaches. I think we'll be doing some more broad-based pricing as we go into 2008.

Sergey Vasnetsov - Lehman Brothers

Okay. And so, could you please clarify your expectations from the customers' inventories. I think you touched on this earlier, but the first quarter of 2007 was impacted by significant adjustments of inventories at one of your large customers. What do you see going into the winter month, between now and March of next year?

Bill Mansfield

I think this question I presume is related again to the Paint segment.

Sergey Vasnetsov - Lehman Brothers

Yes.

Bill Mansfield

And I think our customers' inventories are in reasonably good shape, and I don't anticipate there will be an inventory correction like we experienced last year.

Sergey Vasnetsov - Lehman Brothers

Okay, thank you.

Bill Mansfield

You're welcome, Sergey.

Operator

Your next question comes from the line of Bob Koort from Goldman Sachs. Please go ahead.

Bob Koort - Goldman Sachs

Thank you. Good morning.

Bill Mansfield

Good morning, Bob.

Bob Koort - Goldman Sachs

Couple of questions, I think Paul you might have said that auto refinish was down year-on-year, is that right, and if so, what's going on there?

Paul Reyelts

I don't recall saying that.

Bill Mansfield

No, I don't think that's the case, Bob.

Bob Koort - Goldman Sachs

Okay, good. I must have misheard. And then when I look at what Lowe's had to say today, they talked about a little bit of pick up actually in fourth quarter here, slight they termed it, but they also talked about opening another 10% to the store count next year. I am just wondering is that that the inventory channel fill, is that significant to you or given that it's only 10% of their store base and Lowe's is not 50% of your sales, is it irrelevant?

Bill Mansfield

Yeah, it's not relevant, because there is no year-over-year benefit. New store openings occurred in '07, they are going to occur in '08, they occurred in '06 and relatively around the same size. So, on a year-over-year basis, it's not a significant change.

Bob Koort - Goldman Sachs

And I was wondering if you might, Bill, be able to dumb it down for me. If the U.S. market is going to be weaker and I can't remember the term you used for global market something like reasonable. Would you expect growth outside the U.S. basically to offset whatever slippage you might see in the U.S. or is it something more subtle at play?

Bill Mansfield

No, I think that's fair, the way you just described it. We still expect to grow in the U.S. but certainly not to the extent that we grow outside the U.S. Like Paul talked about, Huarun and some of our other businesses outside the U.S. at high single-digits and that would imply the U.S. business still growing but much, much smaller than that.

Paul Reyelts

And on the bottom line, obviously much tighter control of expenses in the domestic markets and some of the faster growth markets outside of the U.S.

Bob Koort - Goldman Sachs

Got it. Thank you.

Bill Mansfield

You are welcome, Bob.

Operator

Your next question comes from the line of P.J. Juvekar from Citi. Please go ahead.

P.J. Juvekar - Citi

Yes, hi, good morning.

Bill Mansfield

Good morning, P.J.

P.J. Juvekar - Citi

Bill, architectural paint organic growth was negative. Can you just sort of break that down between pricing and volume, so that we know what happened to volumes?

Bill Mansfield

No, I can't. But I will tell you that volumes on a full year basis were negative.

P.J. Juvekar - Citi

Sort of mid single digit?

Bill Mansfield

Yeah.

P.J. Juvekar - Citi

Okay. And then looking into next year, you mentioned that you expect raw material costs to go up 2% to 3%, that sounds conservative, I mean it could be lot more than that given where oil is and given where all the raw materials are going?

Bill Mansfield

I don't disagree that it could be a lot more. We have to pick a planning number that seem to be a reasonable number, and like we did in 2005, if material costs should shoot up more than what we have anticipated, we would take the appropriate pricing steps.

P.J. Juvekar - Citi

Okay. And then your brand advertising for Valspar brand, how does that ramp up has taken place, how does that play out in '08 and when do you begin to ramp down? When do you feel that your advertising is good enough that there is -- are you doing consumer service and when do you think you won't feel the need to advertise as heavily?

Bill Mansfield

Never, we will always advertise. I think what we were trying to communicate is with the launch in 2007 that is clearly the year of greatest expense.

P.J. Juvekar - Citi

Right.

Bill Mansfield

In 2008, it will ramp down by roughly $0.07 a share or $10 million of expense, and then going forward, I would expect that there would be some perhaps modest decline in '09 and '010. But more importantly, as we get through and reach the bottom of the housing impact, we'll start to gain leverage with that advertising expense as we grow our business.

P.J. Juvekar - Citi

Right. And in your mind, how was this advertising or branding campaign taken place so far, have you done any studies with the consumers and what's been the feedback?

Bill Mansfield

Yes. Our consumer awareness numbers have increased significantly month-over-month. We do this on a monthly basis. We use a research firm or we conduct consumer interviews quite scientific in its design.

P.J. Juvekar - Citi

Can you quantify some numbers, you said significantly, but can you just give us some numbers?

Bill Mansfield

I really can't, P.J., that would be a step too far in terms of visibility relative to the competitive environment.

P.J. Juvekar - Citi

Okay. I may come back to you on that later.

Bill Mansfield

That would be fine. Please feel free to call me.

P.J. Juvekar - Citi

Thank you.

Bill Mansfield

You're welcome, P.J.

Operator

Your next question comes from the line of Jeff Zekauskas from J.P. Morgan. Please go ahead.

Silke Kueck - J.P. Morgan

Good morning. This is Silke Kueck for Jeff. How are you?

Bill Mansfield

Fine, Silke.

Silke Kueck - J.P. Morgan

I also have a couple of questions. The strength in the packaging business and the coil business, to what extent is that due to market share opportunities caused by the Akzo ICI merger?

Bill Mansfield

I think that, well, I'll tell you in our packaging business, it's more about technology and it's about having the technology that the customer needs and wants and contributes through efficiency in their operations and that's the primary driver.

Silke Kueck - J.P. Morgan

But it seems those numbers you've given include the market share gains.

Bill Mansfield

I would hope they would, yes.

Silke Kueck - J.P. Morgan

You've given the scaling back of capital outlays. What is the likelihood of $4 million share repurchase to be completed over the next 12 months?

Bill Mansfield

That would be speculative on my part. We have this authorization each year and we would expect to execute on the authorization as market conditions dictate it.

Silke Kueck - J.P. Morgan

Okay, and maybe two more if I can?

Bill Mansfield

Sure.

Silke Kueck - J.P. Morgan

You said that most of your hydrocarbon-based raw materials are going up and how about the mineral-based ones, like pigments, are those also going up?

Bill Mansfield

Well, if you are using titanium dioxide, as an example of a pigment, there is a significant energy component in that. And other than that, I really frankly don't have that level of detail available.

Silke Kueck - J.P. Morgan

And lastly, are there other planned rationalization opportunities that you would have, and where would those be?

Bill Mansfield

There are always opportunities to more efficiently operate the facilities, but the question is directed towards to would we anticipate a manufacturing rationalization, like we went through in '05 and '06. At this point, no, we do not anticipate that.

Silke Kueck - J.P. Morgan

Something on the smaller scale?

Bill Mansfield

We have always continued to do it on a smaller scale. We have never really talked about it a lot in terms of a non-recurring.

Silke Kueck - J.P. Morgan

In the respect [just that since I am on], how important is commercial construction versus residential and what have you seen in the commercial construction market?

Bill Mansfield

Commercial construction is quite important to us, particularly in our coil coatings business, where we have a major position, particularly in the U.S. in commercial building, like industrial metal type manufacturing buildings. And also in Extrusion coatings, which are used in monumental buildings, large office towers.

The second segment that I commented on the Extrusion coatings are doing quite well. That major construction, big offices tends to a lag in downturn and lag in upturn, whereas in our commercial building business we have seen some weakness in the US in the second half of the year in that business.

Silke Kueck - J.P. Morgan

Thank you very much.

Bill Mansfield

You're welcome, Silke.

Operator

Your next question comes from the line of John McNulty from Credit Suisse. Please go ahead.

John McNulty - Credit Suisse

Yeah, good morning.

Bill Mansfield

Good morning, John.

John McNulty - Credit Suisse

With regard to your sales forecast, can you just let me know if that's including currency, and if so, what your assumptions are for FX?

Bill Mansfield

Yes. We will let you know. I don't know if I can answer that question sitting here right now.

John McNulty - Credit Suisse

But it did include foreign currency though?

Bill Mansfield

Yes.

John McNulty - Credit Suisse

Okay. And then in the packaging business with the expectations for double-digit growth, I know you had cited technology as being a big driver behind kind of the growth that you are seeing there. What if any major new platforms have you launched, because it sounds like you are looking for growth, it's about four times kind of the normalized growth rate of the packaging space?

Bill Mansfield

Well, normalized growth rate, the U.S. market, I don't disagree with you, that's about a flat market. But there is significant growth in units occurring in Europe, Middle East, Eastern Europe and Asia also. Asia is a bit of a change from it was several years ago. The unit volumes actually are growing and no surprise are actually growing in China. So, there is an organic growth story there relative to units.

We haven't necessarily launched any brand new platforms in the last couple of months. In this business, product life cycles tend to be quite long. And some of the things, some of the technologies that we introduced several years ago are now starting to gain some pretty good traction. One of which would be, our water-based beverage and coating, and the traction is being gained on a global scale, and we are quite pleased with that progress.

John McNulty - Credit Suisse

Okay, great. And then last question, with your net debt-to-cap now kind of at a pretty manageable level, it looks like it's below 40% again. Would you be more inclined to be buying back stock now or saving up for further bolt-on acquisitions or is it kind of a pick them day-to-day?

Bill Mansfield

I think that's a situational issue, John. We don't tend to look at it on an absolute basis. I think it's more situational.

Paul Reyelts

Our main goal with stock repurchases is to offset dilution from options, and some years we bought a little more, other years we buy a little less, but over time I think our goal is to keep our share count relatively flat. Now, circumstances could suggest we go a little more one direction or the other, but that's our longer-term goal.

John McNulty - Credit Suisse

Okay, great. Thanks for taking my questions.

Bill Mansfield

You're welcome, John.

Operator

You have a follow-up from the line of [James Sheehan] from Deutsche Bank. Please go ahead.

James Sheehan - Deutsche Bank

Thank you. I just want to clarify with Paul on the auto refinish business, I think you were characterizing the drop in gross margin as partially due to lower U.S. volumes in architectural paints, and partially due to auto refinish coatings, could you explain what was the cause for the lower margin there?

Paul Reyelts

What I was trying to suggest is that we had a mix change as it relates to our margin. In other words, softness in architectural and in the auto refinish resulted in having fewer or less sales in higher gross margin segment. Does that make sense to you?

James Sheehan - Deutsche Bank

Okay. So, the overall volumes in auto refinish, could you just characterize them, were they flat or up or what were they?

Paul Reyelts

They were pretty much flat.

James Sheehan - Deutsche Bank

Okay, thanks a lot.

Bill Mansfield

You're welcome, James.

Operator

Your next question is a follow-up from Rosemarie Morbelli from Ingalls & Snyder. Please go ahead.

Rosemarie Morbelli - Ingalls & Snyder

Just quickly, could you remind us what the situation is with Huarun. Are we going to see the end of this minority interest shares or is this going on forever because of the situation there, [your split in] ownership. And if it is going to go on forever, why separate them from operations?

Paul Reyelts

It won't go on forever. There is a put in a call that has a date of -- I think it's July of 2009. And so, we anticipate that either the minority shareholders will put or that we will call at that date. That's our best guess. That's what we're assuming in terms of how the charge is being calculated today.

Rosemarie Morbelli - Ingalls & Snyder

And so, what is going to be the net-net, whether one does one thing or the other thing. What is the net-net in July of '09?

Paul Reyelts

Well, these are relating to the shares that are owned by non-management shareholders. So, we still have some management shareholders that own a small amount, less than 10%. So, the assumption is that the outside shareholders at that point will want to exercise their put. We can't forecast for share, but that's the assumption at this point.

Lori Walker

So, what ends up happening is that mandatory redeemable stock, non-cash charge are seeing, at the time that they put a recall, the entire amount will reverse. So it will be a pick up at that point in time.

Rosemarie Morbelli - Ingalls & Snyder

I see. So this is why we are using it as a non-recurring, because it will reverse itself at the end of the period.

Lori Walker

Right.

Bill Mansfield

Correct.

Rosemarie Morbelli - Ingalls & Snyder

Okay, thanks.

Bill Mansfield

You're welcome.

Operator

And you have a follow-up from Saul Ludwig from KeyBanc. Please go ahead.

Saul Ludwig - KeyBanc Capital Markets

On the incentive comp, I know back in the third quarter year-over-year, it was down and I guess, I assume it was down in the fourth quarter. What was the magnitude of that drop-off in incentive comp in the fourth quarter and for the year?

Bill Mansfield

Well, Saul, I don't have the number in front of me, but year-over-year, there was a drop-off in the fourth quarter. That's a pretty good headwind in 2008. I think it's fair to say, and we also have incorporated that into our guidance.

Saul Ludwig - KeyBanc Capital Markets

When you say a headwind, meaning there will be more of it?

Bill Mansfield

Yeah. We're not going to go two years in a row.

Saul Ludwig - KeyBanc Capital Markets

Do you have any idea what magnitude that in a sense helped your earnings this year?

Bill Mansfield

Not on top of my head, I don't, Saul.

Saul Ludwig - KeyBanc Capital Markets

Okay. And you mentioned that in the higher margin products in the architectural, I know I was under the impression that as you were rolling out the Valspar brand as a signature product, it was moving stronger than just the Valspar brand product, but am I to interpret from your commentary that it was the reverse?

Paul Reyelts

No.

Bill Mansfield

No.

Saul Ludwig - KeyBanc Capital Markets

Then what was the higher margin product that wasn’t selling so well?

Paul Reyelts

Across the Board, architectural gross margins are higher than, say, industrial margins or coatings gross margin as a whole. It goes up with the architectural category, not within the architectural product spectrum.

Saul Ludwig - KeyBanc Capital Markets

All right

Paul Reyelts

Exactly.

Bill Mansfield

So, all we are trying to communicate was in the fourth quarter, our mix was not as rich as it had been in prior quarters.

Saul Ludwig - KeyBanc Capital Markets

Got you. And then, finally, do you think by spending $10 million less in advertising in support of the brand, that’s going to have any negative effect on volume?

Paul Reyelts

It was always going to be a 5-year plan, and we are following a 5-year plan that was put in place probably over a year ago. So, it isn’t like we decided to lower next year, to modify our approach based on circumstances. It just was the plan all along. So, I don’t know if that answers your question, but we are not adjusting to a good or bad environment in terms of our plan for advertising.

Saul Ludwig - KeyBanc Capital Markets

I am just wondering, I know it’s the plan, but if you spend less, do you think it will have any negative effect once you go out the door?

Bill Mansfield

No, Saul. We don't nor do our customers.

Saul Ludwig - KeyBanc Capital Markets

Okay. Thank you very much.

Bill Mansfield

You're welcome, Saul.

Operator

And at this time, there are no further questions.

Bill Mansfield

Well, thank you everyone. We appreciate your attending our year-end conference call. To summarize, a difficult environment in 2007, but we accomplished a number of things strategically. We think we're well positioned going forward in to 2008 to deliver improved financial results and we look forward to speaking with you in February at our first quarter conference call. Thank you everybody.

Operator

Ladies and gentlemen, this conference will be available for replay after 1:30 Central Time today to December 3rd. You may access the AT&T teleconference replay system at any time by dialing 1-800-475-6701 and entering the access code 894063. International participants dial 320-365-3844. Those numbers once again are 1-800-475-6701 or 320-365-3844, with the access code 894063.

That does conclude your conference for today. Thanks you for your participation and for using the AT&T executive teleconference. You may now disconnect.

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Source: Valspar F4Q07 (Qtr End 10/26/07) Earnings Call Transcript
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